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Industry Analysis: Aerospace and Defense 7/23/13 5:51 PM

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Morton L. Siegel Close Window

The Aerospace/Defense Industry serves, as its name represents,
two main markets: Aerospace, which largely comprises the
production, sale, and service of commercial aircraft. And Defense,
which is dependent on the nation's need for military weapons
and systems designed to operate on land, sea, and in the air.
Also included in this industry is the production of general aircraft
(mostly for business use) and space vehicles, usually satellites,
for both military and commercial use.

Most commercial aircraft are sold to the world's airlines. A few
are configured for general aviation use, serving nations,
companies, or individuals that need large aircraft for
transportation outside of those available to the public. Historically, airlines based in the United States have provided the largest
market for commercial aircraft. But in recent years, foreign airlines (many subsidized by local governments) have become the
major source of orders.

The United States military comprises by far, the largest market for defense equipment, systems, and services in the world. The
companies included in this sector not only serve America's needs, but often are the suppliers most sought by our allies and
friends. Aside from political reasons for using U.S. suppliers, American manufacturers, serving the huge domestic defense market,
tend to be leaders in the technical aspects of weapons systems. And warriors have long found that there are no silver medals in
combat, only winners and losers.

The market for airliners has been very cyclical in the past, with orders surging for years, followed by a sharp decline in need,
which results in airlines canceling or postponing their orders. The reason for the sharp turns is traceable to the airlines' leverage.
For example, if breakeven operating capacity is 70%, then 71% would generate a profit, which would tend to surge as the
percentage rises. On the other hand, 69% would result in a deficit. Of course, this is a simplification, but the principle applies.

The market for weaponry has its own cycle. During a war, defense spending rises rapidly, with expenditures on procurement and
research & development (the lifeblood of this industry), climbing at a fast pace, but when the war is over, and/or public
perceptions of risks fade, then spending on defense stops climbing (which may result in a decline in inflation-adjusted spending)
or an actual decline in current dollars. Demands for government money, which tend to rise in times of economic distress, while
tax receipts fall, is another factor that may reduce the priority of defense spending.

Current American defense spending is by far the largest by any nation in the world. The justification for that is the need to provide
the best weaponry and to protect the many diverse national interests around the globe.

Of course, the amount to be spent on the military is a decision that must be made by our national leaders. But as to affordability,
past expenditures provide some guidance. Our current defense spending amounts to about 4% of Gross Domestic Product. But
during the Vietnam War, it amounted to 8.9%; in the Korean War, it was 11.7%; and during World War II, it soared to 34.5%.

The most important programs competed for by these companies tend to be very large. As a result, contractors on such programs
need to be sizable, with considerable financial and personnel resources. In fact, this applies both to the defense and commercial
segments of this group. A couple of decades ago, there were four makers of large jetliners, excluding the Soviet Union, whose
aircraft were generally uneconomic to operate. Now there are only two in ``The West''. The expense of developing a new-type
plane is very expensive in money, other resources, and time. The defense business has also shrunk, with many ``big'' names now
part of their acquirers. There are many niches for subcontractors, however. Indeed, even the biggest companies often provide
subsystems to other corporations' programs. Page 1 of 2
Industry Analysis: Aerospace and Defense 7/23/13 5:51 PM

In recent years, the government has been unwilling to permit the defense industry to make large acquisitions in their field. As a
result, the excess ``Cash Flow'' developed by many of these companies has tended to build up. Dividends have increased, debt
has been paid off, and some companies have spent billions of dollars to retire their common stock during the past five years.

Companies dealing with the government are permitted to include pension charges on programs, although there is an inevitable lag
in such recoveries. At times, the value of pension assets may take a big hit due to a general decline in the value of stocks, real
estate, and other assets. This prompts many of these companies to record a large charge against net worth. But an eventual
recovery in underlying values reverses that provision.

Members of this group are particularly sensitive to the success or failure of programs that they serve. But in most cases, the mix is
very large and complicated. So most investors should focus on the state of the spending ``tide''. As always, Timeliness is
important. And a stock's 3- to 5-year capital-gains potential should be relatively attractive. Page 2 of 2